We have been discussing now for nearly two months that we expect the U.S. economy to accelerate in the second half of the year. The main catalysts we see to propel the economy higher are a fading of the sequester, adaption to the payroll tax hike, increased capital spending by corporations, and falling commodity prices that boost discretionary income and corporate profit margins.
Each passing day reveals this investment thesis is beginning to play out as economic reports are coming in not only stronger than expected, but beating nearly every estimate. For example, the first four purchasing managers index (PMI) readings for June rose over the May reading and beat every single estimate. The last time this happened was April 2009, one month after the 2007-2009 bear market ended and two months before the recession ended.
Economists have a tendency to extrapolate the past into the future, thus at key economic turning points they are typically off by a mile. This was the case back in December 2007 when the U.S. economy slipped into a recession; economists were far too optimistic and their estimates were horribly off the mark. The same occurred in March 2009 as the U.S. economy had been in a recession for more than a year; again, economists were far too pessimistic and missed the bottom in the economy.
As shown above, they are missing the mark again as the U.S. economy is beginning to accelerate from the slowdown seen in the first half of the year. The clean sweep for June seen in the first four PMIs continued yesterday as we had yet another huge day of positive economic surprises, adding further pillars of support to our bullish outlook. Looking at the summary table below for yesterday's economic releases, we see that durable goods orders (a key leading indicator for GDP) came in at 3.6% and ahead of the 3% estimate. Capital goods orders came in at 1.1% versus estimates for 0.5%. The S&P/CaseShiller Home Price Index rose 12.05% over the past year, ahead of the 10.6% estimate. The Richmond Fed Manufacturing Index came in at 8, way above the 2.0 estimate, and the Consumer Confidence Index came in at 81.4, above the 75.1 estimate and hit a 5-year high.
Drilling into two of the reports above, the Richmond Fed Survey had 10 estimates with the highest estimate coming in at 7, while the actual reading came in at 8 and beat every single estimate.
There were 77 estimates for June’s Consumer Confidence Index with the highest estimate coming in at 79.5; the actual number beat all 77 estimates and came in at 81.4! The index jumped another 7 points in June on top of a 5-point rise in May and 7-point gain in April, leaving the index at its highest level since January 2008.
As shown above, economists are underestimating the US economy when recent reports are blowing away all estimates. However, it’s not just economists who are overly pessimistic but also investors, both retail and institutional. Shown below is the National Association of Active Investment Managers (NAAIM) Sentiment Survey which shows institutional investors are more pessimistic now than they were at the 2012 summer lows, back when the market was 20% lower.
Similarly, the put-to-call ratio shows option sentiment currently at levels that have marked meaningful bottoms over the last year.
Readers should know that pullbacks (declines ranging from 5-10%) are far more common than most think and should not be alarmed by the recent decline. Since 1960, there have only been three calendar years in which a 5% or more decline did not occur, indicating there is a 94% probability that we will at least experience one 5% or more decline in the markets every single year. On average, the market experiences at least a 5% decline once every 118 days and so the 128 day rally from the November lows to the May highs was virtually on cue for a decline.
Bulls, or even market historians, would be quick to point out that every 5% pullback does not lead to a full-fledged bear market (20%+ decline). Conversely, bears would point out that EVERY bear market begins as a 5% pullback, which is also true. What both bears and bulls SHOULD know, however, is that most bear markets are associated with recessions as a decline in the economy leads to a decline in corporate earnings and a greater than average drawdown in the market.
So Where’s the Beef?
That recessions and bear markets tend to go hand-in-hand, is one reason why there is so much focus on either predicting or recognizing whether one is taking place. So, how about now? A quick look at the recession probability graph below may shed some light on whether the current decline will turn into a bear market as the bears propose, or if it is just a healthy correction in an ongoing bullish trend as the bulls would suggest. Shown below is a multi-decade look at the S&P 500 (black line), with recessions highlighted by the red bars, along with our Recession Probability Model (red line). Currently, our recession model suggests a 13% chance of the US economy either in or nearing a recession, which would suggest the current decline is likely just a healthy pullback and not a precursor to a bear market.
Market Likely Nearing Intermediate Low
I believe the current decline has been healthy and the current bull market is likely to continue into the second half of the year. There are several subtle messages in the markets indicating this is just a healthy pullback and that the market’s bullish internals remain intact. For example, advance-decline lines for the S&P 500 and the NYSE showed a milder decline and less chart damage than did the headline indexes, indicating a few heavy weights in the indexes were largely responsible for the decline while the vast number of issues have held up reasonably well.
Additionally, looking at relative performances by sectors and market cap relative to the S&P 500 from the May 22nd top to the June 24th bottom also shows an encouraging picture as cyclical sectors, like the consumer discretionary and technology sector, outperformed the S&P 500. The same is true for small caps (S&P 600), while traditionally defensive sectors, like the telecommunication and utility sectors, were the worst performers. This is not the characteristic you see at major market tops.
If we are not putting in a major bull market top then investors have been given the opportunity to put some money to work, which is what they were clamoring for all year as the markets roared higher. Now that the decline is here many of the same investors looking for a correction have headed for the hills. We are nearing levels in the markets associated with intermediate lows and, once again, the opportunity is being given to investors to put money to work at lower prices.
Currently, as seen below, only 33% of the 500 stocks in the S&P 500 have MACD signal lines above a baseline of zero (2nd panel), which is close to the momentum readings seen at the November lows. Also, the percentage of stocks with RSI readings below 30 (deeply oversold) is currently showing a bullish divergence with the S&P 500 (3rd panel) and the percentage of stocks in the S&P 500 below their 50 day moving averages fell below 30% (4th panel), just as it did at the November lows.
The economy continues to improve and looks set to accelerate into the latter part of the year as argued in previous articles. With recent improving economic numbers the likelihood of a recession remains low and argues the current decline is a healthy development in a bullish trend and not a precursor to Armageddon. With sentiment readings hitting extremes as well as technical breadth and momentum indicators hitting levels associated with intermediate lows, we believe investors have been given an opportunity to put money to work in an ongoing bull market and economic expansion.